Commentaries

Last week litigation and enforcement matters took top billing in incidents impacting global financial services firms. Among other things, the US Commodity Futures Trading Commission fined two different entities of one global investment bank for violations of its rules related to the handling of customer funds and position limits. In addition, a High Court in the United Kingdom struck down a proposed rule of the London Metal Exchange aimed at helping lower prices of aluminum worldwide which some claim have been artificially inflated because of long waiting times at warehouses to retrieve the widely-used commercial metal. As a result, the following matters are covered on this week’s Gary DeWaal’s Bridging the Week:

CFTC Fines Two Morgan Stanley Entities over Inadvertent Deficiencies in Their Handling of Customer Funds and Position Limit Violations (includes My View);

UK High Court Sets Aside LME Proposed Rule Aimed to Reduce Waiting Time at Approved Warehouses to Withdraw Metals in order to Reduce Aluminum Prices to Commercial Clients and Consumers;

Principal MF Global Officers Again Fail at Effort to Dismiss a Lawsuit against Them;

FCStone Prevails in Action by Sentinel Management Litigation Trustee to Recapture Funds Paid to the FCM for Its Customers; Separately, Former Sentinel CEO Convicted in Fraud Scheme;

FINRA Fines LPL Financial US $950,000 for Not Having Adequate Supervisory System Related to Its Sale of Alternative Investments;

CFTC Extends Until June 30 Authority of LCH.Clearnet to Provide Clearing Services for Nodal Exchange Contracts without being fully Qualified as a DCO for Such Clearing; and

ESMA Publishes Updated Q&As related to the AIFMD as well as ETFs and UCITs.

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CFTC Fines Two Morgan Stanley Entities over Inadvertent Deficiencies in Their Handling of Customer Funds and Position Limit Violation

Last week, the US Commodity Futures Trading Commission reminded futures commission merchants that it had a zero tolerance for even inadvertent deficiencies regarding the handling of customer funds, no matter that the mistakes caused no harm to any client. It likewise reminded traders that even short-term position limit violations might be punished too. Both reminders were issued in CFTC enforcement actions against two different Morgan Stanley entities.

In response to the CFTC enforcement action against it, Morgan Stanley Smith Barney agreed to pay a US $490,000 fine after it transferred by mistake on April 8, 2013, US $16 Million from a specially protected bank account related to its customers foreign futures and related options trading (a so-called “secured funds account”). This transfer resulted in a one day deficiency of a little over US $9 Million in the amount Morgan Stanley was required to maintain in all its secured funds accounts for its customers. Morgan Stanley discovered its mistake itself and corrected the deficiency on the next day, April 9; it also promptly self-reported its error to the National Futures Association and the CFTC.

In addition, after this episode, Morgan Stanley voluntarily retained KPMG LLP to review its policies and procedures related to its handling of its secured funds accounts as well as accounts with funds of its customers trading domestic futures and related options (so-called “segregated funds accounts”). Morgan Stanley, acknowledged the CFTC, substantially implemented all recommendations subsequently made by KPMG.

The CFTC also found that for eight months in 2012, Morgan Stanley did not accurately compute the amount of its segregated and secured funds (although the firm always maintained at least the minimum required amounts in such accounts), and during six months during 2012, the firm improperly combined customer and a small amount of firm funds in a single customer segregated funds account. For “several months” in 2012, Morgan Stanley mistitled account statements for segregated funds accounts as secured accounts, says the Commission. The CFTC acknowledged that none of Morgan Stanley’s failures resulted in a single dollar of customer loss. However, says the CFTC,

“…the violations demonstrate a lack of adequate internal controls and a failure to diligently supervise the handling of matters related to [Morgan Stanley]'s business as a Commission registrant.”

In a separate CFTC enforcement action against Morgan Stanley Capital Markets, the firm agreed to pay a US $200,000 penalty for violating the all-months CBOT soybean meal futures contract speculative position limit on three days in January 2013. The CFTC currently sets the speculative limit for this futures contract as well as certain other agricultural contracts. After Morgan Stanley first realized it exceeded the all-months position limit on January 14, 2013, it self-reported its violation to the CFTC’s Division of Market Oversight. However, the firm did not reduce its position to below the relevant limit successfully until January 16. The Chicago Mercantile Exchange has recently signaled its aggressiveness in prosecuting position limit violations, even where a violation is intra-day only (see article: “Through Disciplinary Actions, CME Reminds Members (Again) of the Importance of Complying with Rules Regarding Position Limits (Even Intraday) at http://www.garydewaalandassociates.com/?p=2205).

My View: I wish I could include after this article my segment “Compliance Weeds” and provide insight on how FCMs might always comply with applicable CFTC rules related to the handling of customer funds. However, by this point, most reputable FCMs understand their obligations and are pro-actively trying to be in compliance 24/7. However, even the best organization occasionally will make a clerical or other minor error from time to time, and it is unclear the societal benefit of a government agency with limited resources, such as the CFTC, bringing an enforcement action in connection with each and every incident. This is especially the case where as here the firm making the error, Morgan Stanley, not only fixed and self reported its error, but voluntarily engaged an independent consulting firm to assist it reduce the likelihood of making further errors going forward. At a minimum, to conserve resources, the CFTC should consider enacting a formal policy to offer potential respondents an opportunity to settle enforcement matters related to certain types of offenses for a nominal fine in an expedited process where no customer has been harmed and the potential respondent (1) promptly self reports the offense (excluding offenses involving fraud or manipulation); (2) promptly corrects the offense; (3) voluntarily retains the assistance of a third party consultant to make recommendations to avoid future, similar violations; and (4) agrees materially to implement such consultant’s recommendations on a timely basis. The CFTC’s Division of Enforcement could institute this policy by revising its Enforcement Advisory “Cooperation Factors in Enforcement Division Sanction Recommendations,” that have not been updated since 2007 (see: http://www.cftc.gov/ucm/groups/public/@cpdisciplinaryhistory/documents/file/enfcooperation-advisory.pdf).

UK High Court Sets Aside LME Proposed Rule Aimed to Reduce Waiting Time at Approved Warehouses to Withdraw Metals in order to Reduce Aluminum Prices to Commercial Clients and Consumers

The London Metal Exchange’s efforts to reduce the price of aluminum worldwide was dealt a significant setback when the High Court in London ruled last week in favor of a challenge by United Company Rusal plc. After a public consultation, the LME on November 7, 2013, proposed a rule that would link the amount of LME-traded metal an exchange approved warehouse could accept for storage to the amount of the same metal it released whenever the warehouse could not process requests to release the relevant metal from storage in less than 50 days.

It was hoped that this proposed rule would shorten a widespread back up in aluminum deliveries from LME approved warehouses that critics claimed artificially raised the price of aluminum and ultimately aluminum products sold to commercial clients and consumers. This is because the cumulative total of storage charges assessed by a warehouse on stored metal increases over time.

Rusal, an aluminum producer, challenged the consultation process. The company claimed that the LME’s proposed rule would financially hurt producers like itself, and that the LME never adequately considered this potential harm, as it was required. The company claimed that other alternatives, such as limiting the storage charges that warehouses could assess on stored metals beyond a certain number of days, would also reduce the price of relevant metals (such as aluminum) without harming producers. The Court sided with Rusal.

The LME expressed “disappointment” with the Court’s decision but noted that, although the Court,

“…found in favour of Rusal on one particular procedural issue, namely that the Consultation should have encompassed or made reference to the option of banning or capping rent in queues, but otherwise found in the LME's favour on the other procedural and substantive points raised by Rusal, including as to whether a cost-benefit analysis is required, alleged apparent bias on the part of the LME, and the changes to the queue threshold for the Rule.”

Rusal, in a company press release, expressed its appreciation that the LME would now be required to “carry out a fair and lawful consultation process which addresses the concerns of a number of market participants raised prior to and following the initial consultation process.”

The LME’s proposed rule was scheduled to take effect this week on April 1. It won’t. (For background on the LME Warehouse controversy, see article “FCA Issues Statement Regarding LME Warehouses” at http://www.garydewaalandassociates.com/?p=1371.)

FCStone Prevails in Action by Sentinel Management Litigation Trustee to Recapture Funds Paid to the FCM for Its Customers; Separately, Former Sentinel CEO Convicted in Fraud Scheme

On March 19, 2014, an US Federal Appellate Court in Chicago ruled that funds paid to FCStone, a futures commission merchant, for its customers just prior to and after the insolvency of Sentinel Management Group on August 17, 2007, should not be returned to the bankruptcy estate. A US Federal District Court in Chicago previously had ruled that funds paid to FCStone from the failed company should be returned.

Sentinel was an investment management firm that claimed it specialized in short-term cash management for hedge funds, individuals, financial institutions and FCMs like FCStone.

Unknown to its clients, Sentinel improperly commingled securities purchased with its different types of customers’ funds. Ultimately Sentinel paid its FCM customers, like FCStone with the proceeds of some of these securities just prior to the firm’s insolvency filing, and then right afterward, the Bankruptcy Trustee authorized further payments to FCMs.

The District Court ruled that FCStone had to return these funds, saying otherwise the class of FCMs would unfairly receive a preference over other customers that deserved equal protection.

The Appellate Court reversed the District Court’s decision. It claimed that the pre-bankruptcy payment to FCStone should not be disallowed as it was a so-called “settlement payment” made in connection with a securities contract; these type of pre-bankruptcy payments are typically deemed legitimate by a failing company and cannot be subsequently voided by a bankruptcy trustee. Likewise the Appellate Court claimed that the post-bankruptcy payment should also not be reversed because a bankruptcy court expressly authorized it, and a reversal now would detrimentally impact today’s customers and investors of FCStone, not those who benefitted in 2007.

(For a discussion regarding the August 2013 ruling of the same Appellate Court regarding whether the Bank of New York (now BNY Mellon) appropriately protected itself by asserting a lien on certain assets of Sentinel prior to its insolvency, see the article “Sentinel Lender Must Again Face Trial to Determine Whether Disputed Funds Held Under a Lien are Owed to Customers” at: http://www.garydewaalandassociates.com/?p=1134.)

Separately, Eric Bloom, the former Sentinel CEO, was convicted last week by a Federal jury in Chicago of defrauding customers in excess of US $500 Million related to the Sentinel collapse. Mr. Bloom now awaits sentencing. Previously, Charles Mosley, Sentinel’s former head trader, pled guilty to investment adviser fraud last October 2013; he also awaits sentencing.

And briefly:

Principal MF Global Officers Again Fail at Effort to Dismiss a Lawsuit against Them: A US Federal District Court judge in New York City on March 24, 2014, rejected the efforts of three former principal MF Global Holdings officers to dismiss a lawsuit against them by the MF Global Litigation Trustee. The Trustee had alleged that John Corzine, Henry Steenkamp and Bradley Abelow had breached their fiduciary duties of care and loyalty to the company. The Defendants justified their motion to dismiss, claiming, “nothing happened at MF Global which a single one of the …Defendants could possibly bear any legal responsibility.” The judge, the Hon. Victor Marrero, held that defendants’ motion was premature at this point, and that the Trustee’s Complaint should proceed. Just a few weeks ago, the same Judge dismissed causes of actions in their entirety against some of the Firm’s former officers and against its former accounting firm in connection with the customer class action lawsuit against MF Global and certain of its officers; the Judge at the time also dismissed some but not all charges against Messrs. Corzine, Steenkamp, and Abelow, and three other former officers (for more information, see article “Some Defendants and Former Accounting Firm Dismissed in Private Class Action Lawsuit Involving Customers of MF Global” at http://www.garydewaalandassociates.com/Commentary/PostDetails/1934#.U1GMeV5vl_g).

FINRA Fines LPL Financial US $950,000 for Not Having Adequate Supervisory System Related to Its Sale of Alternative Investments: The Financial Industry Regulatory Authority fined Boston-based LPL Financial LLC, a registered broker dealer, US $950,000 for failing to maintain an adequate supervisory system from 2008 through 2012 related to its sale of alternative investments. Specifically, FINRA alleged that, during this time, the firm did not have reasonable systems or procedures to identify and determine whether purchases of non-traded real estate investment trusts, oil and gas partnerships, business development companies, equipment leasing programs, real estate limited partnerships, hedge funds, managed futures and other illiquid pass-through investments resulted in customers’ accounts being inappropriately concentrated in alternative investments, contrary to the firm’s own suitability standards, as well as applicable prospectus and state requirements. FINRA claimed LPS also did not adequately train its supervisory staff regarding such suitability standards. Although LPL agreed to settle this matter, as part of its settlement, it submitted a “Corrective Action Statement” in which it described “…the many actions it has taken related to the issues described in the [FINRA public announcement].” According to LPL, “[t]hese enhancements, which began in 2012 and continue through the present, came about through LPL’s self-identification of ways to improve the Firm’s supervision of the processing and sales of alternative investments.”

CFTC Sets FCM Outside Auditor Independence Standards: Late Friday afternoon, the CFTC’s Division of Swap Dealer and Intermediary Oversight issued an Interpretation stating that any auditor that meets Securities and Exchange Commission and Public Company Accounting Oversight Board independence requirements applicable to broker dealers will also meet the requirements of independence under CFTC’s rules related to futures commission merchants.

CFTC Extends for an Additional Month No-Action Relief Previously Granted SGX related to Swaps Clearing for US Customers: The CFTC extended until April 30, 2014, the authority of non-FCM registered Singapore Exchange clearing members to carry or to accept for liquidation of existing positions new orders for OTC Commodity Contracts for (1) US customers or (2) customers of an FCM that clear through an FCM omnibus account. This authority was initially granted in December 2013 but was set to expire on March 31. The authorization is subject to various conditions.

CFTC Extends Until June 30 Authority of LCH.Clearnet to Provide Clearing Services for Nodal Exchange Contracts without being fully Qualified as a DCO for Such Clearing: The CFTC extended until June 30, 2014, relief initially granted to LCH.Clearnet Ltd and the Nodal Exchange LLC in September 2013 for LCH to provide clearing services for Nodal Exchange contracts prior to LCH’s Designated Clearing Organization status being amended to accommodate clearing services for the Nodal Exchange. The initial relief had been scheduled to expire on March 31.

ESMA Publishes Updated Q&As related to the AIFMD as well as ETFs and UCITs: The European Securities and Markets Authority published Updated Questions and Answers related to the Alternative Investment Fund Managers Directive as well as Exchange Traded Funds and other issues under the Undertakings for Collective Investment in Transferable Securities. The revised Q&As related to the AIFMD address reporting to national competent authorities, while the updated Q&As regarding UCITS deal with guidelines on financial indices. Previously the European Commission published a Q&A on AIFMD too.

The information contained in this article is not legal advice. For legal advice, please consult with your attorney. The information in this article is derived from sources believed to be reliable as of March 29, 2014, but no representation or warranty is made regarding the accuracy of any statement. To ensure compliance with requirements imposed by U.S. Treasury Regulations, Gary DeWaal and Associates LLC informs you that any U.S. tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Gary DeWaal and Associates may represent one or more entities mentioned in this article.